Should Netflix Be Worried About Apple?

Netflix‘s stock has fallen more than 10% following reports that Apple is in talks with Comcast about a streaming service via AppleApple TV. Apple wants ComcastComcast to offer a managed service that will ensure high streaming quality and bypass web congestion. Technically speaking, such distinction is recognized and does not overstep on net neutrality rules as Apple wants a separate route for its videos and not a preferential treatment on common public route. Although the negotiations are still in early stages, a precedent has been set for a more competitive online streaming market in the future. This does not bode well for NetflixNetflix, which has managed to post impressive growth over the years, capitalizing on its early market entry and competitive advantage. Not only does Apple have the capability to attract a large customer base, its entry will also push content prices up. Also, if its streaming standards surpass those of Netflix, the latter will face some serious challenge, assuming Apple prices its service competitively.

We estimate that Apple sold roughly 15.5 million Apple TV devices in 2012 and 2013 combined. Sales in the prior years were much lower, which leads us to believe that the current installed base could be in the vicinity of 17 million. This is the potential customer base for Apple’s expected streaming service, and is likely to grow rapidly going forward. Apple’s overall customer base is much larger if we include iPhone and iPad users. The company’s customers tend to be loyal and launching a streaming video service could encourage a lot of them to try it out. It won’t be surprising if some of them drop Netflix, if the quality of Apple’s video content is comparable and pricing is competitive. We have no doubts that the user experience is likely to be good, especially if the talks with Comcast go through. Apple has more than enough cash to pay for some juicy content deals, including exclusive and original content, which makes it a very dangerous competitor for Netflix. While the company primarily makes money from hardware sales, its recent moves suggest it has ambitions of controlling digital content distribution as well. Last year, Apple launched its Internet radio service to challenge Pandora on its turf.

Nevertheless, Apple is not the only competitor that Netflix needs to worry about. An analyst from Macquarie stated last year that Amazon has confirmed it has over 20 million Amazon Prime members globally. The company has been competing with Netflix for a long time in the online streaming business but had been mute about its membership base. The revelation suggests that it has become a force to reckon with, and could spell trouble for Netflix in the coming quarters. Amazon has also started taking advantage of its distribution capabilities to expand its streaming business and plans to sell set-top boxes of its own.

If increasing competition were to restrict Netflix’s domestic streaming subscriber base to just 45 million by 2020, there could be 10% downside to our current price estimate.

Costs Can Shoot Up Going Forward

One of the primary concerns that Netflix faces is rising content costs as its off-balance sheet content obligations have surpassed $7.25 billion. However, the company has been able to grow its contribution margins by expanding its user base and gaining operating leverage. If Apple successfully challenges Netflix, the latter’s user base growth could slow down and content costs as a percentage of revenues could shoot up. Additionally, with Apple and others bidding on the same content, Netflix may have to shell out more from its pocket. None of this is favorable for the company. We currently forecast domestic streaming contribution margins to grow from 24.9% in 2013 to over 37% by 2020. However, there can be a downside of about 12%-15% to our price estimate if the figure was to increase to only 30%.

But these are not the only costs that Netflix needs to worry about. If Apple can build a solid service with clear advantage over Netflix in terms of streaming quality, it may force the latter to strike similar deals and pay additional amount to compete effectively.

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